Freddie Mac 2004 Annual Report Download - page 114

longer-term period and a pay-Ñxed swap with the same maturity is the substantive economic equivalent of a
long-term debt instrument of comparable maturity. Similarly, the combination of non-callable debt and a
swaption, or option to enter into a receive-Ñxed swap, with the same maturity as the non-callable debt, is the
substantive economic equivalent of callable debt. The ability to either issue debt or synthetically create its
substantive economic equivalent through derivatives increases funding Öexibility, allows us to better match
asset and liability cash Öows and often reduces the overall funding cost.
Hedge Foreign-Currency Exposure. We also use derivatives to hedge foreign-currency exposure
associated with foreign currency denominated debt issuances, such as our 4Reference Notes» securities
program, as discussed above in ""Sources of Interest-Rate Risk and Other Market Risks Ì Retained
Portfolio Ì Foreign Currency Risk.'' Through the use of derivatives, we are able to mitigate nearly all
currency risk at the time of debt issuance.
Adjust Funding Mix. As market conditions dictate, we undertake rebalancing actions in order to keep
our interest-rate risk exposure within management limits. As interest rates decline, mortgage prepayments
tend to increase and the expected life of mortgages tends to decrease. In this environment, we typically enter
into receive-Ñxed swaps or purchase Treasury-based derivatives to adjust the duration of our funding to oÅset
the declining mortgage duration. As interest rates increase, prepayments tend to decrease and lengthen the
expected life of mortgages. In this case, we typically enter into pay-Ñxed swaps or sell Treasury-based
derivatives in order to adjust the duration of our funding to oÅset increasing mortgage duration.
Types of Derivatives. We use derivatives that are common in the Ñnancial markets to conduct our risk
management activities. The majority of our derivative positions fall into the following four categories:
‚ LIBOR-based interest-rate swaps;
‚ LIBOR- and Treasury-based exchange-traded futures;
‚ LIBOR- and Treasury-based options (including swaptions); and
‚ Foreign currency swaps.
In addition to swaps, futures and options, our derivative positions include certain purchase and sale
commitments and other contractual agreements including swap guarantee derivatives and credit risk-sharing
agreements discussed further below.
Forward Purchase and Sale Commitments. We routinely enter into forward purchase and sale
commitments for mortgage loans and mortgage-related securities. Most of these commitments are derivatives
subject to the requirements of SFAS 133 and accordingly must be recorded at fair value on our consolidated
balance sheets.
Prepayment Management Agreement. Practices of seller/servicers may aÅect prepayment levels on
mortgages that underlie PCs. As a result, mortgages underlying some PCs may be prepaid faster than similar
mortgages underlying other PCs, adversely aÅecting our management and guarantee income and the
performance of our mortgage-related securities. We have taken steps to achieve prepayment experience on
PCs that is consistent with market norms. Beginning in 2002, we required that certain mortgage pools
delivered to us between 2001 and 2003, which we considered to pose elevated risk of prepayment, be covered
by a prepayment management agreement to partially compensate us for the adverse Ñnancial impacts caused
by disproportionately higher mortgage prepayments. We also oÅered an incentive through an adjusted
guarantee fee level on certain mortgage deliveries when the prepayment experience of the mortgage pools is
within deÑned ranges. This type of agreement is accounted for as a derivative in accordance with SFAS 133
and classiÑed as no hedge designation, with changes in fair value recorded as Derivative gains (losses) on the
consolidated statements of income. This type of agreement is reÖected at fair value on our consolidated
balance sheets in the Derivative assets, at fair value, or Derivative liabilities, at fair value, caption. At
December 31, 2004 and 2003, approximately $113.7 billion and $152.5 billion, respectively, of the mortgages
underlying PCs included in our Total mortgage portfolio (see ""Table 8 Ì Freddie Mac's Total Mortgage
Portfolio Based on Unpaid Principal Balances'') were subject to this type of agreement. Amounts due to us
under this type of agreement are reported as a component of our Management and guarantee income.
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